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Strategic Management II
1. Industry analysis - Chapter 8
Porter’s Five Competitive Forces
It is a framework to analyze the
economic factors that affect the
profitability of an industry. To perform a
five-force analysis we apply on the
economics of the firm and industrial
organization. Also some knowledge
about institutions (rules of the game) in
the industry is crucial.
- Internal Rivalry The firm’s direct competitors (we have to define the market in order to identify them) reduce its market share and revenue margins.
- The threat of internal rivalry depends on: The intensity of competition in the product market.
The effective degree of differentiation.
The possible degree of collusion.
The factors to consider are: - Number of competitors in the market, concentration.
- Product differentiation, switching costs, network effects.
- Collusion / cooperation, observability of prices, ability to adjust prices quickly, large and infrequent sales orders, etc.
- Installed capacity.
- Cost asymmetries (incentives to drive out of the market high-cost competitors).
- Industry life cycle (in expansion / decline).
- Exit barriers - Entry Future entrants can become direct competitors, intensifying internal rivalry in the industry.
The threat of entry depends on: - The attractiveness of the industry and the presence of entry barriers.
- Structural entry barrier.
- Strategic entry barriers.
The factors to consider are: - Economies of scale, the learning curve, or significant network effects.
- Access to key inputs (know-how, raw materials, distribution channels, locations).
- Value of reputation / brand loyalty.
1 - Expectations about post-entry competition.
Government protection of incumbents - Substitutes Substitute products erode the profits of the firm, while complements aid the firm. They influence internal rivalry as well as entry and exit in the industry (e.g. threat of lateral entry).
The factors to consider are: - Presence of substitutes: products that satisfy similar needs and whose functional features are different.
- Price / quality (or value) proposition of substitutes.
- Price elasticity of industry demand - Bargaining power of suppliers and buyers Suppliers and buyers with market power can erode profits. More precisely, concentrated suppliers (upstream monopoly), concentrated buyers (downstream monopsony) and firms with the hold-up problem. But, even in the absence of market power among suppliers and buyers, changes or fluctuations in those segments of the market will affect the firm.
The factors to consider are: - Concentration and intensity of competition among suppliers and buyers.
- Presence of asset specificity (the hold-up problem).
- Threat of forward / backwards integration with suppliers / buyers.
- Existence of substitute inputs.
- Ability of suppliers to engage in price discrimination or purchasing volume discrimination with clients Implications and Limitations of Porter’s framework Can suggest strategic responses: - Strategies to respond to the threats present and develop competitive advantages based on cost or differentiation.
Strategies to minimize the firm’s exposure to the threats present, so occupy industry segments where the threats are lower.
Strategies to reduce the threats present, just like strategic commitment, cooperation with rivals, vertical integration, etc.
But it may have also some limitations: - Factors that may affect demand (e.g. evolving consumer preferences, changes in income, advertising…).
Complementary products and ecosystems that generate value are not considered.
Governmental intervention and the regulatory context.
Qualitative analysis. Useful to evaluate trends, but difficult quantitative application.
2 - Focus on the industry rather than the firm.
Brandenburger and Nalebuff’s Value Net The firm’s interactions with other industry players (competitors, suppliers, or buyers) do not always represent a threat. Positive interactions can increase the profit pie for all participants, and the firm should seek opportunities for cooperation in the industry. They use the term ‘coopetition’ to refer to these interactions. The value net captures the set of interactions where these opportunities can be generated.
Some examples of coopetition like: - Cooperation in the supply chain to increase the efficiency in production or the quality of the product.
Joint setting of technology standards with competitors Efforts to promote regulation favorable to the industry (Network neutrality (high-tech vs. Communication), Nutrition pyramid (Food industry lobby)…).
Two-sided Platforms In markets with two-sided platforms, the product or service supplied by the platforms serve two types of agents, which facilitates interaction between agents of different types. For example, to see the interactions: - A game player benefits from more game developers because it increases the variety of games available and lowers their prices.
- A game developer benefits from more players because it leads to a larger market and hence higher prices and lower average costs.
- So, there are positive inter-group network externalities between both types of agents.
The platform sets prices for both sides of the market (for both types of agents), even if they transact with each other at a later date. The platform’s pricing policy must account for the network externalities (or network effects) present among both types of agents. The externalities imply that there are positive interactions between members of the value net, and the platform must exploit them to succeed. This may imply pricing policies which differ for both types of agents, in some cases incurring losses on one side of the platform to increase its overall value. So a monopoly can charge a “negative price” (subsidize) or set prices below average costs if it leads to an increase in total profits.
3 In numbers: A platform serves two types of agents and sets price for each side, and . The agents on one side of the platform derive utility from the participation of agents on the other side. This utility can be written as: and , where is the number of members participating on side i, and captures the intensity of the externality between both sides.
Every group of agents participates only on its side of the platform, and decides whether to participate or not. Assume that: and . In addition, the platform has a cost for each side. So the profits of the platform are: .
Other approach: instead of maximizing through prices, maximize with respect to utilities.
[ ] [ ] The optimal prices for the platform satisfy: Note that: - - A lower price on one side not only attracts the price sensitive consumers on that side but also, as a result, leads to more participation of consumers on the other side. The increased value extracted from the other side magnifies the value of having consumers on the first side, which leads to a yet bigger price decrease and quantity increase on the other side… The optimal prices on each side reflect: o The cost of serving an agent on that side.
o Adjusted downward by the external benefit to the other group.
o Adjusted upwards by a factor related to the elasticity of the group’s participation.
Aftermarkets Durable goods generate aftermarkets (or secondary markets) for complementary products.
There are network effects given that the size of the primary market determines the size of the aftermarket (The value net must also incorporate the opportunities that arise in aftermarkets). A large difference with respect to two-sided platforms is that firms cannot restrict access to the aftermarket by third-party producers.
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